Germany: 261. Scope of Subject-To-Tax Clauses in German Tax Treaties

This article was first published in International Tax Review May 2002, p. 58.

For editorial cut-off date, disclaimer, and notice of copyright see end of this article.

In a recently published decision dated 19 December 2001, the Cologne Tax Court interpreted language contained in Article 23 (3) of the tax treaty between Germany and Canada as a subject-to-tax clause, and gave this clause precedence over provisions in the treaty by which items of income "shall be taxable only" in Canada. While the interpretation of treaty Article 23 (3) as a subject-to-tax clause is not new, the relation of this clause to language in the treaty by which items of income are taxable "only" in a specified treaty state is highly controversial and of considerable practical significance.

Germany's tax treaties generally follow the OECD model treaty for the avoidance of double taxation on income and capital, which contains numerous clauses providing that certain items of income or capital "shall be taxable only in" a specified treaty state. For instance, the business profits of an enterprise of a contracting state "shall be taxable only in that State" unless the enterprise carries on business in the other contracting state through a permanent establishment situated therein (Article 7 (1) OECD model tax treaty). Articles 8, 12, 13, 15, 18, 19, 21, and 22 of the OECD model tax treaty, dealing with income from water and air transport, royalties, capital gains, employment, private and public sector pensions, government salaries, and "other income" employ the same language.

The case decided by the Cologne Tax Court involved salary paid by Canada to an individual with Canadian and English citizenship who was employed as a member of the Canadian embassy staff in Germany. While the individual in question was resident in Germany and hence subject to German income tax on her worldwide income under German domestic tax law, Article 19 (1) (a) of the applicable tax treaty provided that her government-paid salary "shall be taxable only" in Canada. Normally, such income would have been taxable in Canada and excluded from the German tax base (arguably not even subject to a progression clause). Canada, however, failed to exercise its right of taxation, allegedly because sec. 115 (e)(i) of the Canadian income tax code exempted the income in question if it was subject to income taxation in the source state. The taxpayer asserted that the contributions paid out of her salary to Germany's statutory pension and unemployment insurance funds constituted German income taxation for purposes of the Canadian statute.

The court agreed with the tax authorities that the treaty's avoidance-of-double-taxation clause (specifically, Article 23 (2) (a)), requires Germany to exclude income taxable in Canada, or taxable only in Canada, from its tax base only where such income is from Canadian sources. Article 23 (3) of the tax treaty provides that income is from sources in a particular contracting state when taxed in that state in accordance with the treaty. While Article 23 (3) does not state that income is from sources in a specific treaty state only when taxed in that state, the court read the clause in this manner, i.e. as a subject-to-tax clause, and found that the income was not from Canadian sources within the meaning of Article 23 (a), hence that it was taxable in Germany.

The Cologne Tax Court allowed an appeal from its judgement to the Federal Tax Court for final decision (docket number I R 14/02). The most important issue posed by the case is not whether Article 23 (3) is a subject-to-tax clause, which is the prevailing view, but rather whether Article 23 is applicable in the first place to income which, by the terms of Article 19, "shall be taxable only in" Canada.

The significance of the case transcends its specific facts because numerous German tax treaties contain variously worded subject-to-tax clauses, and virtually all German tax treaties follow the OECD model in employing "shall-be-taxable-only-in" clauses in the instances discussed above.

In conclusion, it should be noted that the case here discussed was decided under the 1981 tax treaty between Canada and Germany, not the new treaty signed in Berlin on 19 April 2001, which entered into force on 28 March 2002. Interestingly, the clause at issue in the case here reported on has been deleted from the new tax treaty in favour of a modified clause providing for German switch-over from the exemption method of avoiding double taxation to the credit method in specified circumstances.

Editorial cut-off date: 20 April 2002

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